Input trade liberalisation, institution and markup: Evidence from China's accession to the WTO

• Author: Qilin Mao,Jiayun Xu
• Published date: 01 December 2019
• Date: 01 December 2019
• DOI: http://doi.org/10.1111/twec.12872

World Econ. 2019;42:3537–3568. wileyonlinelibrary.com/journal/twec

|

3537

© 2019 John Wiley & Sons Ltd

Received: 5 February 2018

|

Revised: 4 May 2019

|

Accepted: 1 June 2019

DOI: 10.1111/twec.12872

ORIGINAL ARTICLE

Input trade liberalisation, institution and markup:

Evidence from China's accession to the WTO

QilinMao1

|

JiayunXu2

1Center for Transnationals' Studies,Institute of International Economics,Collaborative Innovation Center for China

Economy,Nankai University, Tianjin, China

2Asia–Pacific Economic Cooperation (APEC) Study Center,Collaborative Innovation Center for China Economy,Nankai

University, Tianjin, China

Funding information

Special Program of Talents Development for Excellent Youth Scholars in Tianjin, Grant/Award Number: TJTZJH‐

QNBJRC‐2‐23; National Natural Science Foundation of China, Grant/Award Number: 71773055; Fundamental Research

Funds for the Central Universities, Grant/Award Number: 63192144; Major Projects of the National Social Science

Foundation of China, Grant/Award Number: 18ZDA078; Nankai University's Training Plan for 100 Young Discipline Leaders

KEYWORDS

firm markups, input tariff liberalisation, institutional environment

1

|

INTRODUCTION

Since the early 1990s, theChinese government has introduced a series of trade liberalisation policies (e.g.,

lowering tariff rates, removing import quotas and licences, reducing import and export controls and so

forth) to facilitate market economic reform and integrate into the world multilateral trade system.

Especially, following China's accession to the World Trade Organization (WTO) in December 2001,

China entered a new period of rapid trade liberalisation. It is worth noting that the average input tariffs

decreased from around 11.1% before China's WTO accession to about 6.2% in 2007, which dropped by

approximately 44.1%.1 An important question that arises is how does input trade liberalisation influence

Chinese manufacturing firms' performance after China's accession to the WTO, in particular, whether

input trade liberalisation affects firms' competitiveness? As markup reflects the ability that a firm main-

tains the price over marginal cost in imperfect market, and thus, it is one of the important signs of firms'

competitiveness. In this paper, we investigate the linkage between input trade liberalisation and firm mark-

ups, and thus to shed light on how does firms' competitiveness respond to input tariff liberalisation.

In reality, in addition to the ‘open‐door’ policy, the ‘deepened economic reform’ policy is another

fundamental doctrine of the Chinese government after 1978, which means that a centrally planned

economy was gradually transformed into a market‐oriented one. Especially, China's accession to the

WTO was also accompanied by the development of domestic institutional environment, in particular,

the marketisation index increased from 4.12 in 1998 to 7.50 in 2007, and the annual growth rate was

1 This is calculated by the authors using tariff data; see Section 2 for more details on the construction of input tariff.

3538

|

MAO And XU

7.8;%2 in addition, the marketisation level and institutional environment differ significantly across

regions3 in China. Thus, another important question that arises is whether the impacts of input tariff

liberalisation on firm markups depend on institutional environment where the firms are located?

The paper is related to at least two strands of the growth literature. The first related strand of the lit-

erature is on the nexus between input trade liberalisation and firms' performance. Most previous studies

mainly focus on the effects of input trade liberalisation on firm productivity. For instance, Schor (2004)

analyses Brazilian manufacturing firms from 1986 to 1998 and finds that input tariff reductions signifi-

cantly increase firm productivity. Amiti and Konings (2007) use firm‐level data on Indonesia from 1991

to 2001 and show that firms' productivity gains from reduction in input tariffs are at least twice as much

as those from reduction in output tariffs; in addition, they argue that the primary reason for this result

is that access to better intermediate inputs through the reduction in input tariffs is more important than

the pro‐competitive effect arising from lower output tariffs. Recently, Yu (2015) studies the connection

between tariff reductions and firm productivity, based on Chinese firm‐level data from 2002 to 2006. He

finds that both input and output tariff reductions increase firm productivity, and the effects are weaker as

firms' share of processing imports grows. Furthermore, numerous empirical studies focus on the effects

of input trade liberalisation on firms' export; Bas (2012), for example, utilises detailed firm‐level data

from Argentina, and she forcefully demonstrates that input tariff reductions not only significantly lead

to firms' export participation, but also raise firms' export sales shares. Tian and Yu (2017) also show

that input trade liberalisation is positively correlated with both of firms' export participation and export

intensity by using Chinese firm‐level data for 2000–06. Still, Teshima (2009) examines the effects of

trade liberalisation on firms' innovation using Mexican data and finds that both of output and input tariff

reductions induce firms to increase R&D. Fan, Li, and Yeaple (2015) argue that tariff reductions induce

an incumbent firm to increase the quality of its exports based on Chinese firm‐level data. Similarly, Bas

and Strauss‐Kahn (2015) explore the effects of input trade liberalisation on imported input and exported

product prices, and the results show that firms exploit the input trade liberalisation to upgrade the quality

of their inputs in order to upgrade the quality of their exported products.

Our study is also related to the literature on the determinants of firm markups. Theoretically,

Melitz and Ottaviano (2008) develop a monopolistically competitive model of trade with firm hetero-

geneity and show that larger markets exhibit tougher competition resulting in lower average markups

and higher aggregate productivity; moreover, firm markups are positively related to firm export inten-

sity. Kugler and Verhoogen (2012) extend the Melitz's framework by including endogenous choice of

input and output quality and suggest that if the scope for quality differentiation is sufficiently large,

then more capable plants purchase higher‐quality inputs, sell higher‐quality outputs, charge higher

prices and thus have higher markups. Empirically, Konings, Cayseele, and Warzynski (2005) use

Bulgarian and Romanian manufacturing firm‐level data to investigate the impacts of privatisation

and competitive pressure on firm's price–cost margin, and the results reveal that privatisation leads to

higher price–cost margin and such an effect is stronger in highly competitive sectors. Using French

manufacturing census data, Bellone, Musso, Nesta, and Warzynski (2010) demonstrate that markups

are higher for more productive firms and for exporting firms, which is consistent with theoretical

framework suggested in Melitz and Ottaviano (2008). In a recent influential paper, De Loecker and

Warzynski (2012) investigate the link between exporting behaviour and firm markups using data from

Slovenian manufacturing during the period 1994–2000. They find that exporters charge higher mark-

ups than nonexporters and that markups increase upon export entry.

2 This is calculated by the authors based on a study conducted by Fan et al. (2010).

3 It is worth noting that ‘region’ corresponds to ‘province’ in this paper.

|

3539

MAO And XU

Besides, some researchers have been paying more attention to the effects of trade liberalisation on

markups directly. The earlier empirical studies are based on industry‐level data, for instance, Goldar

and Aggarwal (2005) use panel data for 137 three‐digit Indian industries to examine the relationship

between trade liberalisation and price–cost margins, and the results show that tariff cuts significantly

reduce price–cost margins, and such an impact is particularly stronger in the concentrated industries.

Noria (2013) explores the impact of the North American Free Trade Agreement (NAFTA) on Mexican

manufacturing price–cost margins for the period 1994–2003, and he finds that price–cost margins

immediately decreased once the second round of trade liberalisation under NAFTA in Mexico had

commenced, while in subsequent years, no clear pattern emerged for the markups. Unlike the above

studies using industry‐level data, De Loecker, Goldberg, Khandelwal, and Pavcnik (2016) investigate

the effects of output and input tariff reductions on firm markups based on Indian firm‐level data, and

they document that pro‐competitive effects of output tariff reductions lead to lower firm markups,

while input tariff reductions significantly raise firm markups. In the context of China, Fan, Gao, Li,

and Luong (2017) look into the connection between input trade liberalisation and firm markups using

the custom data merged with firm‐level production data, and they show that input tariff reductions

raise product markups and such an impact is only applied to ordinary trade. Further, using the same

data set, Liu and Ma (2015) investigate the impacts of input trade liberalisation on the markup of

importers versus non‐importers, and the results show that input tariff reductions tend to increase im-

porting firms' markup but not for non‐importers, and they also demonstrate that the positive impact of

input tariff reductions on importers' markup is stronger in less competitive industries. More recently,

Xiang, Chen, Ho, and Yue (2017) explore the heterogeneous effects of trade liberalisation on firm

markups, and they demonstrate that the impact of tariff reduction on markups is more pronounced

for ordinary trade firms and non‐SOEs; in addition, the effect of input tariff reduction is weaker for

more‐concentrated industries. Although the recent literature mentioned above have increased our un-

derstanding of how firm markups adjustment in response to input trade liberalization, however, our

knowledge about this issue is far from complete, especially in the context of China, not much has

been done regarding the role of domestic institutional environment played in the relationship between

input trade liberalization and firm markups. Cowan and Neut (2007) show that better institutional

environment allows firms to gain access to more relationship‐specific inputs, and consequently raises

productivity, but they do not touch on the effect of input tariffs. Recently, some researchers have

paid attention to the role of institutional environment when exploring the nexus between trade liber-

alisation and firm performance. For example, Ahsan (2013) uses Indian firm‐level data to examine

the complementarities between the speed of contract enforcement and the productivity gains from

input tariff reductions, and he demonstrates that the positive impact of input tariff reductions on firm

productivity is normally stronger in those states with abetter institutional environment (i.e., higher

judicial efficiency). To our knowledge, however, there have been no empirical studies that directly

explore whether the impacts of input trade liberalisation on Chinese firm markups hinge on domestic

institutional environment. This study aims to fill in this gap, in particular, we exploit the fact that sub-

stantial input tariff reductions due to China's WTO accession were accompanied by the development

of domestic institutional environment, and take a step forward to investigate the interaction between

the institutional environment and the response of firm markup adjustment to input tariff liberalisation.

To identify the causal effects of input tariff liberalisation on firm markups, we take China's ac-

cession to the WTO as a quasi‐natural experiment and perform difference‐in‐differences (DID) es-

timation. In particular, we treat the firms in industries with previously higher input tariff level (i.e.

the industries experiencing greater input tariff reductions upon WTO accession; see Section 3 for a

detailed discussion) as treatment group, and the firms in industries with previously lower input tar-

iff level (i.e., the industries experiencing less input tariff reductions) as control group, and then, we